IndexIQ: Bringing Momentum To Bond Investing: Part 2

July 27, 2016

[The following "ETF Industry Perspective" is sponsored by IndexIQ]

It’s been quite a run for the bond market. Consider that it was June 1981 when then Federal Reserve Chairman, Paul Volcker, raised the federal funds rate to 20 percent. Two years earlier, Fed funds had averaged just over 11 percent. As a result, by 1982, Volcker had inflation in retreat, rates started to come down, and they’ve been falling more or less ever since.

Long‐term bond investors have benefited greatly from this downward momentum. The trend, as they say, has been their friend for most of the last three decades. More recently, rates have continued to defy attempts to rekindle inflation by global central banks, with some fixed-income instruments now in negative territory.

What’s been important for investors is not just the direction, but also the persistence of those movements in one direction or another. To better understand what this means, our research group took a look at more than 50 years of monthly returns: from 1963 to 2015. They included eight major fixed-income segments in their data gathering, from short‐term Treasurys and 10‐year Treasurys to mortgage‐backed securities and investment-grade and high-yield corporate bonds. They created a “what if” scenario, involving two hypothetical investors, one buying on momentum, investing in the two fixed-income segments that performed the best during the past 12 months; and the other a contrarian, investing in the two segments that had declined the most in value, expecting a reversal of recent trends.

While not all of the segments were available for the entire periodmortgage‐backed securities were added in 1976, and investment-grade and high-yield corporate bonds were included starting in 1980, for example—this enabled a study of the momentum effects in the full range of fixed-income categories over a 35‐year+ period.

What our research group found was that the momentum investor outperformed the contrarian investor, including periods of both rising (1970s and 1980s) and declining (1990s to the present) bond yields. The momentum advantage was consistent in both, outperforming the contrarian investor in 62 percent of the periods (33 out of 53 years).

Historically, The Trend Was Your Friend In Fixed-Income Investing
(Based on hypothetical $100 Investment: The momentum investor invests in the top two-performing fixed-income segments versus the contrarian investor, who invests in the bottom two performing fixed-income segments of the prior year.)

 

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The momentum investor also achieved a substantially higher 7.9 percent average annual return than the contrarian investor’s 5.2 percent. Moreover, despite this sizable return difference, volatility was roughly the same for both investors. In fact, the momentum investor experienced a slightly lower standard deviation of 5.7 percent versus 6.5 percent.

Given the state of the world according to bond pricesjust recently, yields on German bunds went negativea contrarian approach may have a certain appeal. For most of us, having to pay to hold government bonds is a little mind-boggling. But the data is clearover most periods of time, a momentum strategy, as we define it here, will outperform the contrarians, regardless of market direction. More broadly, the research shows that a systematic, rules‐based strategy can work, and is worth considering for fixed income as well as equity investors.

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